Analysts Flip-Flop on Oil Again

Includes: DBO, OIL
by: Andy So

I caught the following quote from this Yahoo Article on yesterday's fall in crude oil prices:

“I don’t think there’s anything they [OPEC] can say at this point,” said analyst Stephen Schork, who doesn’t expect a sustained rally in oil prices during the first half of this year.

“They didn’t have control of oil prices when it was on the way up,” he said. “They don’t have control of it when it’s on the way down.”

It’s amazing how different the oil tune sounds from analysts. I remember less than a year ago how analysts cited fundamental demand being the driving force behind crude oil prices and how OPEC would never let the price of oil fall below $80. Analysts cited demand from emerging economies, mainly China and India, as the driving force behind existing physical demand. With prices having collapsed over 70% in slightly over half a year, did more than 70% of the people in China or India stop driving cars?

For that matter, will 70% of the people in the world stop driving cars, stop taking airplanes and stop using heating oil? Automobiles, Heating, Airlines etc. will still continue to function and be required since they are a part of our global infrastructure and life needs. Physical demand will be curbed due to a global recession, but some basic demand will always be present. Global crude oil usage definitely hasn’t fallen by 70%+ and isn’t expected to fall by such a wide margin from current use. Roughly five years ago, analysts began harping crude oil prices and they quickly forgot that crude oil traded in the $20 range and below for a solid decade before that.

Crude Oil Prices Since 1947 from

I do agree with analysts, that there was a necessary premium attached to crude oil prices over fears of political instability and war negatively impacting the supply side of the equation. Those fears are still in the market today. With that premium in place, a smooth and steady rise in crude prices, in lock-step with real physical supply and demand, should have been what we experienced from oil’s initial rise. Financial instruments instead mucked with real market supply and demand.

This all goes to show that speculation above fundamental demand was the driving force behind rising oil prices. All manner of speculation led to structured products that were tied to spot prices and futures contracts. These notes and products almost never entailed some form of physical delivery and often included some form of principal protection so losses were converted into dollar terms. Bankers created products tied to future production by private firms and made bets on spot prices that had nothing to do with taking some form of delivery in a certificate form or storing barrels of oil.

The lax regulation among these products is similar to the lax regulation with short-selling. Most shorts don’t have physical shares to deliver when they are required to cover positions and short volumes can exceed the actual number of physical shares available. Fundamental physical demand may not have done so much to drive up prices as some analysts considered. Previously available liquidity and interest in structured products has nearly evaporated, causing the current collapse in prices. In many ways, the fall in crude oil is the result of forced deleveraging since many people are selling anything they can, including derivative notes and futures contracts, in order to raise cash.

What the Yahoo article quote above also accurately illustrates is that trusted analysts have no better idea apart from you or I what the price of oil will be tomorrow. The price collapse in crude has put tremendous pressure on giant oil trusts like PWE, Penn West Energy, one my previous picks for its enormous dividend payment. Production costs haven’t fallen in-line with the fall in physical prices and until they do I expect that there will be additional operation suspensions and downward pressure on energy related shares.

Once oil prices stabilize in a illiquid market, we will see true market supply and demand without the influence of the highly leveraged credit, structured products and derivatives industry.

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